Friday, December 7, 2012

Why equity investors keep shunning the big banks

Why equity investors keep shunning the big banks:
THE FinancialTimesreports today that Deutsche Bank may have hid $12 billion in losses during the teeth of the financial crisis. (For those interested in the mechanics of what is alleged to have happened, these twoarticles are well worth reading.) There are many interesting details to this story, such as the fact that DB’s general counsel at the time, Robert Khuzami, has been the head of enforcement at America’s Securities and Exchange Commission (SEC) for the past several years. Perhaps most interesting, however, is that this helps explain an intriguing phenomenon: investors appear to believe that many banks are worth more dead than alive.
Investors appear to feel this way because of the price to book ratios they have been assigning to banks. This measure compares the market value of a firm’s tangible common equity (literally the share price multiplied by the number of shares outstanding) against its book value (the stated value of its assets minus the face value of its liabilities). The price side of the ratio tells you what investors think about the firm’s future profitability. The book side tells you what it would theoretically be worth if it had to go into bankruptcy and liquidate all of its assets. (In practice, of course, firms that go into bankruptcy are often forced to sell their assets at steep discounts, thereby lowering their liquidation value below their theoretical book value. This is even truer for financial firms.)
Healthy firms are worth more alive than dead because they create value and employ productive people. They therefore have price/book ratios greater than 1. But many big banks and other financial firms have ratios below 1, sometimes far below. Bank of America’s market value is only 28% of its book value. Morgan Stanley has a ratio of only 0.48. Even the redoubtable J.P. Morgan only can manage a price/book ratio of 0.71.
One explanation has been that agglomeration destroys value; the markets want big firms to split into smaller and more focused units. For example, an article in today’s Wall Street Journal argues that this motivated Citi’s new CEO to fire 11,000 workers:

Citi is still in need of reinvention. Even after rising more than 6% Wednesday, the stock trades at 70% of tangible book value. In other words, investors continue to believe Citi is worth more broken up than alive. Such discounts to net worth, which are seen at many other global banks, reflect deep-seated questions about banking business models in light of changing financial markets, tougher regulation and the superlow interest-rate environment. This is prompting firms to rethink their structures.

This is surely part of the story. New capital regulations (rightly) promise to penalise banks for getting too big, so it makes sense for firms to shrink. Moreover, megabanks are hard—if not impossible—to manage. Remember Jamie Dimon’s difficulty dealing with the so-called “London Whale”?
But there is another, darker, reason why investors have been taking such a dim view of banks: they worry that the banks’ accounts are not accurate. In other words, they believe that the book value of many banks is too high. The reason why does not really matter. There is little material difference for an investor between a bank that deliberately lies about its balance sheet, as may have been the case with Deutsche, and one that is simply incompetent at measuring risk.
In addition, smart investors have been worrying about banks’ hidden legal liabilities. The foreclosure fraud settlement was actually pretty lenient from the banks’ perspective, but it could have been far worse. There is still a raft of civil litigation from investors arguing that banks misled and mistreated them. Banks are also dealing with charges of money-laundering, bid-rigging, and of course the LIBOR scandal. Given what investors already know, they would be unwise to assume that all of the skeletons have been exhumed from the banks’ closets.
Many people have been arguing that “uncertainty” has been stifling business investment and depressing equity prices. Usually this is a euphemism for saying that the government has been interfering with the markets. When it comes to banks, there are plenty of extra reasons for investors to be uncertain. The most recent story about Deutsche simply adds to a long list of reasons to stay out. Perhaps if the government had been more zealous at prosecuting wrongdoers and extracting pounds of flesh from senior employees of firms that received bail-outs, investors would now feel safe putting their money back in the markets. But that path was not taken.